Part I. Rulings — Internal Revenue Bulletin 2011-50

Section 2036.—Transfers With Retained Life Estate

26 CFR 20.2036–1: Transfers with retained life es- tate.

T.D. 9555

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 20

Graduated Retained Interests

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations that provide guidance on the portion of property (held in trust or otherwise) includible in the grantor’s gross estate if the grantor has retained the use of the property, the right to an annuity, unitrust, graduated retained interest, or other payment from the property for life, for any period not ascertainable without reference to the grantor’s death, or for a period that does not in fact end before the grantor’s death. The final regulations will affect estates that file Form 706, United States Es- tate (and Generation-Skipping Transfer) Tax Return.

DATES: Effective Date: These regulations are effective on November 8, 2011.

Applicability Date: For dates of applicability, see §20.2036–1(c)(3).

FOR FURTHER INFORMATION CONTACT: Theresa M. Melchiorre at (202) 622–3090 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

On April 30, 2009, proposed regulations (REG–119532–08, 2009–20 I.R.B. 1017) were published in the Federal Reg- ister (74 FR 19913). The proposed regulations provide the method required to determine the portion of trust corpus of a

grantor retained annuity or unitrust trust (GRT) that is includible in the grantor’s gross estate under section 2036 if the deceased grantor retains an interest described in §25.2702–3(b)(1)(ii)(A) or (b)(1)(ii)(B) or §25.2702–3(c)(1)(ii); that is, the interest retained by the grantor increases annually during the term of the trust (a graduated retained interest). This method would apply to graduated retained interests in transferred property whether or not held in trust.

In addition, the proposed regulations would add §20.2036–1(c)(1)(ii), Example 1, illustrating the amount includible under section 2036 if the decedent transfers property in trust pursuant to the terms of which trust income is payable to the decedent and decedent’s child, C, in equal shares during their joint lives and, on the death of the first to die of decedent and C, all trust income is to be paid to the survivor. The proposed regulations also would amend §20.2036–1(b)(1)(ii) to address the method required to determine the amount includible under section 2036 if the decedent and C were entitled to receive annuity interests rather than trust income.

Written comments were received on the proposed regulations. No public hearing was scheduled because no individual or organization requested the opportunity to provide oral comments at a hearing. All comments are available at www.regulations.gov or upon request. The proposed regulations, with certain changes made in response to the written comments received, are adopted as final regulations.

Summary of Comments and Explanation of Provisions

Section 20.2036–1(b)(1)(ii) Determining the portion includible if the decedent’s retained annuity follows a preceding annuity interest .

Section 20.2036–1(b)(1)(ii) of the proposed regulations provides the method required to compute the amount includible in the decedent’s gross estate under section 2036 in a situation where the decedent is to receive a payment (or an increased payment) after the death of another beneficiary who is receiving an annuity or other payment at the time of the

decedent’s death. If the decedent predeceases the other beneficiary, under the proposed regulations, the amount includible is the greater of: (1) the amount of cor- pus required to generate sufficient income to pay the annuity payable to the decedent as of the date of death; or (2) the amount of corpus required to produce sufficient income to satisfy the annuity or other payment the decedent would have been entitled to receive if the decedent had survived the other beneficiary, reduced by the present value of the other beneficiary’s interest. The amount includible, however, cannot exceed the fair market value of the trust corpus on the date of death.

One commentator opined that this method attributes to the decedent a greater portion of a trust’s value than is appropriate, because the method does not take into account any depletion of trust principal that is assumed if the annuity payable to the current recipient is a greater percentage of the trust corpus than the assumed rate of return based on the applicable section 7520 rate. Alternatively, the commentator proposed that the amount includible under section 2036 should be the sum of: (1) the amount of trust corpus required to produce sufficient income to satisfy the annuity or other payment the decedent was receiving at death; plus the lesser of: (A) the amount of trust corpus required to produce sufficient income to satisfy the additional annuity payable to the decedent if the decedent had survived the current recipient; or (B) the fair market value of the corpus on the date of the decedent’s death less the present value of the current recipient’s annuity.

The requested approach in the comment was not adopted because it is inconsistent with the existing regulations. The regulations have provided, historically, that if the decedent retained or reserved an interest or right with respect to all or a portion of the property transferred, then the amount includible under section 2036 is the value of the property with respect to which the decedent retained the interest less the value of any outstanding income interest that is not subject to the decedent’s retained interest and that is being enjoyed by another person at the time of decedent’s

2011–50 I.R.B. 838 December 12, 2011

Also in response to a comment, the manner of computing the amount to be included in the decedent’s gross estate has been clarified at the end of §20.2036–1(c)(2)(i).

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations and, because these regulations do not impose on small entities a collection of information requirement, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding this regulation was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Theresa M. Melchiorre, Office of Associate Chief Counsel (Passthroughs and Special Industries), IRS.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 20 is amended as follows:

PART 20—ESTATE TAX; ESTATES OF DECEDENTS DYING AFTER AUGUST 16, 1954

Paragraph 1. The authority citation for part 20 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 20.2036–1 is amended by:

Revising paragraph (b)(1)(ii).
Adding two sentences at the end of paragraph (c)(1)(i).
Adding paragraph (c)(1)(ii) Example 1 .
Removing the third sentence of paragraph (c)(2)(i) and adding three new sentences in its place.

death. Nevertheless, once this computation has been completed, a ceiling on the amount includible in the gross estate under section 2036 (specifically, the fair market value of the trust at death) is imposed. The method in the proposed regulations implements this principle. This method has been clarified in the final regulations by providing that, solely for the purpose of calculating the present value of the current recipient’s interest in this computation, the exhaustion of trust corpus test described in §20.7520–3(b)(2) is not to be applied in cases where §20.7520–3(b)(2) would otherwise require it to be applied.

Clarification of §20.2036–1(c)(1)(ii), paragraph (i) of Example 1 .

In response to a comment, paragraph (i) of Example 1 in §20.2036–1(c)(1)(ii) has been revised to clarify that the present value of C’s outstanding life estate reduces only the 50 percent of trust corpus from which it is payable.

Section 20.2036–1(c)(2)(ii) — Amount includible in the case of a graduated retained interest .

In response to a commentator’s request for a detailed example, a step-by-step illustration of the method described in §20.2036–1(c)(2)(ii) (renumbered as §20.2036–1(c)(2)(iii) in the final regulations) has been added in Example 7 of §20.2036–1(c)(2)(iv).

Section 20.2036–1(c)(2) — Inclusion under sections 2036 and 2033 .

One commentator requested that the regulations clarify the interaction of sections 2033 and 2036 in a situation where the decedent establishes a GRT under the terms of which the retained interest is paid to the decedent for a specified term of years and, if the decedent dies prior to the expiration of that term, the retained annuity or other payment is to be paid to the decedent’s estate for the balance of the term. See for example §25.2702–3(e), Example 5 .

The commentator noted that, because all or a portion of the trust corpus is includible in the decedent’s gross estate under section 2036, the annuity or other payments that become payable after the decedent’s death and are required to be paid

to the estate for the remainder of the trust term are reflected in the amount includible under section 2036, and therefore should not also be includible under section 2033.

The IRS and the Treasury Department agree. To the extent that all or a portion of the trust corpus is includible in the gross estate under section 2036 as a result of the decedent’s retained annuity or other interest, double inclusion of the same asset would result if any payment that becomes payable after the decedent’s date of death to the estate also is included in the decedent’s gross estate under section 2033 as a separate item. Accordingly, §20.2036–1(c)(1)(i) of the regulations has been revised to provide specifically that payments that become payable to the decedent’s estate after the decedent’s death (as opposed to payments that are payable to the decedent prior to the decedent’s death but are not paid until after the decedent’s death) are not subject to inclusion under section 2033, if section 2036 is applied to include all or a portion of the trust corpus in the gross estate. This rule is also reflected in §20.2036–1(c)(2)(iv), Example 2 paragraph (ii) and Example 7 . The payments described in the preceding paragraph are to be distinguished, however, from annuity or other payments payable to the decedent prior to the decedent’s date of death, but that are not paid until after death. Such payments are includible in the decedent’s gross estate under section 2033 as a separate receivable. Thus, such an amount payable by the trust reduces the fair market value of the trust as of the date of death, but is included in the decedent’s gross estate under section 2033 as a receivable amount.

Organizational changes to and clarification of §20.2036–1(b) and (c) .

In response to comments, the method set forth in §20.2036–1(b)(1)(ii) of the proposed regulations for calculating the amount includible if part or all of the decedent’s retained annuity follows an annuity interest payable to another at the time of the decedent’s death has been moved to a separate section, §20.2036–1(c)(2)(ii). As a conforming change, paragraph (ii) of Example 1 of §20.2036–1(c)(1)(ii) has been moved and renumbered as Example 8 of §20.2036–1(c)(2)(iv) in the final regulations.

December 12, 2011 839 2011–50 I.R.B.

Redesignating paragraphs (c)(2)(ii) and (c)(2)(iii) as paragraphs (c)(2)(iii) and (c)(2)(iv), respectively.
Adding new paragraph (c)(2)(ii) and text to newly-designated paragraph (c)(2)(iii).
Revising the introductory text of and adding Example 7 and Example 8 to newly-designated paragraph (c)(2)(iv).
Adding two sentences at the end of paragraph (c)(3).

The revisions and additions read as follows:

§20.2036–1 Transfers with retained life estate.

- - - (b) - - (1) - - (ii) A decedent reserved the right to receive the income, annuity, or other payment from transferred property after the death of another person who was in fact enjoying the income, annuity, or other payment at the time of the decedent’s death. In such a case, the amount to be included in the decedent’s gross estate under this section does not include the value of the outstanding interest of the other person as determined in paragraphs (c)(1)(i) and (c)(2)(ii) of this section. See also, paragraphs (c)(1)(ii) Example 1 and (c)(2)(iv) Example 8 of this section. If the other person predeceased the decedent, the reservation by the decedent may be considered to be either for life, or for a period that does not in fact end before death.
- - - (c) - - (1) - - (i) - - - If this section applies to an interest retained by the decedent in a trust or otherwise and the terms of the trust or other governing instrument provide that, after the decedent’s death, payments the decedent was receiving during life are to continue to be made to the decedent’s estate for a specified period (as opposed to payments that were payable to the decedent prior to the decedent’s death but were not actually paid until after the decedent’s death), such payments that become payable after the decedent’s death are not includible in the decedent’s gross estate under section 2033 because they are properly reflected in the value of the trust corpus included under this section. Pay

ments that become payable to the decedent prior to the decedent’s date of death, but are not paid until after the decedent’s date of death, are includible in the decedent’s gross estate under section 2033.

(ii) - - * Example 1 . Decedent (D) creates an irrevocable inter vivos trust. The terms of the trust provide that all of the trust income is to be paid to D and D’s child, C, in equal shares during their joint lives and, on the death of the first to die of D and C, all of the trust income is to be paid to the survivor. On the death of the survivor of D and C, the remainder is to be paid to another individual, F. Subsequently, D dies survived by C. Fifty percent of the value of the trust corpus is includible in D’s gross estate under section 2036(a)(1) because, under the terms of the trust, D retained the right to receive one-half of the trust income for D’s life. In addition, the excess (if any) of the value of the remaining 50 percent of the trust corpus, over the present value of C’s outstanding life estate in that 50 percent of trust corpus, also is includible in D’s gross estate under section 2036(a)(1), because D retained the right to receive all of the trust income for such time as D survived C. If C had predeceased D, then 100 percent of the trust corpus would have been includible in D’s gross estate.

- - - (2) - * (i) * * * The portion of the trust’s corpus includible in the decedent’s gross estate for Federal estate tax purposes is that portion of the trust corpus necessary to provide the decedent’s retained use or retained annuity, unitrust, or other payment (without reducing or invading principal). In the case of a retained annuity or unitrust, the portion of the trust’s corpus includible in the decedent’s gross estate is that portion of the trust corpus necessary to generate sufficient income to satisfy the retained annuity or unitrust (without reducing or invading principal), using the interest rates provided in section 7520 and the adjustment factors prescribed in §20.2031–7 (or §20.2031–7A), if applicable. The computation is illustrated in paragraph (c)(2)(iv), Examples 1, 2, and 3 of this section. - * *

(ii) Decedent’s retained annuity follow- ing a current annuity interest of another person . If the decedent retained the right to receive an annuity or other payment (rather than income) after the death of the current recipient of that interest, then the amount includible in the decedent’s gross estate under this section is the amount of trust corpus required to produce sufficient income to satisfy the entire annuity or other payment the decedent would have been entitled to receive if the decedent had survived the current recipient (thus, also in

cluding the portion of that entire amount payable to the decedent before the current recipient’s death), reduced by the present value of the current recipient’s interest. However, the amount includible shall not be less than the amount of corpus required to produce sufficient income to satisfy the annuity or other payment the decedent was entitled, at the time of the decedent’s death, to receive for each year. In addition, in no event shall the amount includible exceed the value of the trust corpus on the date of death. Finally, in calculating the present value of the current recipient’s interest, the exhaustion of trust corpus test described in §20.7520–3(b)(2) (exhaustion test) is not to be applied, even in cases where §20.7520–3(b)(2) would otherwise require it to be applied. The following steps implement this computation.

(A) Step 1 : Determine the fair market value of the trust corpus on the decedent’s date of death.

(B) Step 2 : Determine, in accordance with paragraph (c)(2)(i) of this section, the amount of corpus required to generate sufficient income to pay the annuity, unitrust, or other payment (determined on the date of the decedent’s death) payable to the decedent for the trust year in which the decedent’s death occurred.

(C) Step 3 : Determine, in accordance with paragraph (c)(2)(i) of this section, the amount of corpus required to generate sufficient income to pay the annuity, unitrust, or other payment that the decedent would have been entitled to receive for each trust year if the decedent had survived the current recipient.

(D) Step 4 : Determine the present value of the current recipient’s annuity, unitrust, or other payment (without applying the exhaustion test).

(E) Step 5 : Reduce the amount determined in Step 3 by the amount determined in Step 4, but not to below the amount determined in Step 2.

(F) Step 6 : The amount includible in the decedent’s gross estate under this section is the lesser of the amounts determined in Step 5 and Step 1.

(iii) Graduated retained interests —(A) In general . For purposes of this section, a graduated retained interest is the grantor’s reservation of a right to receive an annuity, unitrust, or other payment as described in paragraph (c)(2)(i) of this section, payable at least annually, that increases (but does

2011–50 I.R.B. 840 December 12, 2011

not decrease) over a period of time, not more often than annually.

(B) Other definitions —( 1 ) Base amount . The base amount is the amount of corpus required to generate the annuity, unitrust, or other payment payable for the trust year in which the decedent’s death occurs. See paragraph (c)(2)(i) of this section for the calculation of the base amount.

( 2 ) Periodic addition . The periodic ad- dition in a graduated retained interest for

each year after the year in which decedent’s death occurs is the amount (if any) by which the annuity, unitrust, or other payment that would have been payable for that year if the decedent had survived exceeds the total amount of payments that would have been payable for the year immediately preceding that year. For example, assume the trust instrument provides that the grantor is to receive an annual annuity payable to the grantor or the grantor’s

(1) Annual Payment

(2) Prior Year

Payment

estate for a 5-year term. The initial annual payment is $100,000, and each succeeding annual payment is to be 120 percent of the amount payable for the preceding year. Assuming the grantor dies in the second year of the trust (whether before or after the due date of the second annual payment), the periodic additions for years 3, 4, and 5 of the trust are as follows:

(1 - 2) Periodic Addition

Year 3 144,000 120,000 24,000 Year 4 172,800 144,000 28,800 Year 5 207,360 172,800 34,560

second is 1 divided by the sum of 1 and the section 7520 rate raised to the T power (1 / (1 + rate)^T). The second factor applies a present value discount to reflect the period beginning with the date of death and ending on the last day of the trust year immediately before the year for which the periodic addition is first payable.

( i ) The corpus amount is determined as follows:

( 3 ) Corpus amount . For each trust year in which a periodic addition occurs (increase year), the corpus amount is the amount of trust corpus which, starting from the decedent’s date of death, is necessary to generate an amount of income sufficient to pay the periodic addition, beginning in the increase year and continuing in perpetuity, without reducing or invading principal. For each year with a periodic

addition, the corpus amount required as of the decedent’s date of death is the product of two factors: the first is the result of dividing the periodic addition (adjusted for payments made more frequently than annually, if applicable, and for payments due at the beginning, rather than the end, of a payment period (see Table K or J of §20.2031–7(d)(6)) by the section 7520 rate (periodic addition / rate)); and the

(Periodic Addition) x (Adjustment Factor) 1

Section 7520 Rate

( ii ) The adjustment factor, if applicable, is the factor for payments made more frequently than annually and for payments due at the beginning, rather than the end, of a calendar period (see Table K or J of §20.2031–7(d)(6)). T equals the time period in years from the decedent’s date of death through the last day of the trust year immediately before the year for which the periodic addition is first payable.

(C) Amount includible . The amount includible in the gross estate in the case of a graduated retained interest is the sum of the base amount and the corpus amount for each year for which a periodic addition is first payable. The sum of these amounts represents the amount of trust principal that would be necessary to generate the an

nual payments that would have been paid to the decedent if the decedent had survived and had continued to receive the graduated retained interest. The amount of trust corpus includible in a decedent’s gross estate under this section, however, shall not exceed the fair market value of the trust corpus on the decedent’s date of death. The provisions of this section also apply to graduated retained interests in transferred property not held in trust.

(iv) Examples . The application of paragraphs (c)(2)(i), (c)(2)(ii), and (c)(2)(iii) of this section is illustrated in the following examples:

- - - Example 7 . (i) On November 1, year N, D transfers assets valued at $2,000,000 to a GRAT. Under the

(1+ Section 7520 Rate) ^T

terms of the GRAT, the trustee is to pay to D an annuity for a 5-year term that is a qualified interest described in section 2702(b). The annuity amount is to be paid annually at the end of each trust year, on October 31st. The first annual payment is to be $100,000. Each succeeding payment is to be 120 percent of the amount paid in the preceding year. Income not distributed in any year is to be added to principal. If D dies during the 5-year term, the payments are to be made to D’s estate for the balance of the GRAT term. At the end of the 5-year term, the trust is to terminate and the corpus is to be distributed to C, D’s child. D dies on January 31st of the third year of the GRAT term. On the date of D’s death, the value of the trust corpus is $3,200,000, the section 7520 interest rate is 6.8 percent, and the adjustment factor from Table K of §20.2031–7 is 1.0000. D’s executor does not elect to value the gross estate as of the alternate valuation date pursuant to section 2032.

December 12, 2011 841 2011–50 I.R.B.

(ii) The amount includible in D’s gross estate under section 2036(a)(1) as described in paragraph

(c)(2)(iii)(C) of this section is determined and illustrated as follows:

A GRAT Year	B Annual Annuity Payment	C Periodic Addition	D Required Principal: C x Adj. Factor / 0.068	E Deferral Period: Death to GRAT Year	F Present Value Factor: 1/(1+.068)^E	G Corpus or Base Amount At Death: D x F
3	144,000	n/a	2,117,647	n/a	n/a	2,117,647
4	172,800	28,800	423,529	0.747945	0.951985	403,193
5	207,360	34,560	508,235	1.747945	0.891372	453,026
					Total:	2,973,866

(iii) Specifically: (A) Column A . First, determine the year of the trust term during which the decedent’s death occurs, and the number of subsequent years remaining in the trust term for which the decedent retained or reserved an interest. In this example, D dies during year 3, with two additional years remaining in the term.

(B) Column B . Under the formula specified in the trust, the annuity payment to be made on October 31 ^st

of the 3 ^rd year of the trust term is $144,000. Using that same formula, determine the annuity amounts for years 4 and 5.

(C) Column C . Determine the periodic addition for year 4 and year 5 by subtracting the annuity amount for the preceding year from the annuity amount for that year; the periodic addition for that year is the amount of the increase in the annuity amount for that year.

(v) A total corpus amount (as defined in paragraph (c)(2)(iii)(B)( 3 ) of this section) of $2,973,866 constitutes the principal required as of decedent’s date of death to produce (without reducing or invading principal) the annual payments that D would have received if D had survived and had continued to receive the retained annuity. Therefore, $2,973,866 of the trust corpus is includible in D’s gross estate under section 2036(a)(1). The remaining $226,134 of the trust corpus is not includible in D’s gross estate under section 2036(a)(1). The result would be the same if D’s retained annuity instead had been payable to D for a term of 5 years, or until D’s prior death, at which time the GRAT would have terminated and the trust corpus would have become payable to another.

(vi) If, instead, D’s annuity was to have been paid on a monthly or quarterly basis, then the periodic

(D) Columns D through G for year 3 . For the year of the decedent’s death (year 3), determine the principal required to produce the annuity amount (Column D) by multiplying the annuity amount (Column B) by the adjustment factor (in this case 1.0000) and by dividing the product by the applicable interest rate under section 7520. Because this is the year of decedent’s death and reflects the annuity amount payable to the decedent in that year, there is no deferral, so this is also the Base Amount (the amount of corpus required to produce the annuity for year 3) (Column G).

(E) Columns D through G for years 4 and 5 . For each succeeding year of the trust term during which the periodic addition will not be payable until a year subsequent to the year of the decedent’s death, determine the principal required to produce the periodic addition payable for that year (Column D) by multi

addition would have to be adjusted as provided in paragraph (c)(2)(iii)(B)( 3 ) of this section. Specifically, in Column D of the Table for years 4 and 5 in this example, the amount of the principal required would be computed by multiplying the periodic addition by the appropriate factor from Table K or J of §20.2031–7(d)(6) before dividing as indicated and computing the amounts in Columns E through G. In addition, Column D in year 3 also would have to be so adjusted. Under the facts presented, section 2039 does not apply to include any amount in D’s gross estate by reason of this retained interest. See §20.2039–1(e).

Example 8 . (i) D creates an irrevocable inter vivos trust. The terms of the trust provide that an annuity of $10,000 per year is to be paid to D and C, D’s child, in equal shares during their joint lives. On the death of

plying the periodic addition (Column C) by the adjustment factor and by dividing the product by the applicable interest rate under section 7520. Compute the factors to reflect the length of the deferral period (Column E) and the present value (Column F) as described in paragraph (c)(2)(iii)(B)( 3 ) of this section. Multiply the amount of corpus in Column D by the factors in Columns E and F to determine the Corpus Amount for that year (Column G).

(F) Column G total . The sum of the amounts in Column G represents the total amount includable in the gross estate (but not in excess of the fair market value of the trust on the decedent’s date of death).

(iv) An illustration of the amount of trust corpus (as of the decedent’s death) necessary to produce the scheduled payments is as follows:

the first to die of D and C, the entire $10,000 annuity is to be paid to the survivor for life. On the death of the survivor of D and C, the remainder is to be paid to another individual, F. Subsequently, D dies survived by C. On D’s date of death, the fair market value of the trust is $120,000 and the section 7520 rate is 7 percent. At the date of D’s death, the amount of trust cor- pus needed to produce D’s annuity interest ($5,000 per year) is $71,429 ($5,000/0.07). In addition, assume the present value of C’s right to receive $5,000 annually for the remainder of C’s life is $40,000. The portion of the trust corpus includible in D’s gross estate under section 2036(a)(1) is $102,857, determined as follows:

2011–50 I.R.B. 842 December 12, 2011

(ii) Step 1 : Fair market value of corpus . $120,000

(iii) Step 2 : Corpus required to produce D’s date of death annuity ($5,000/0.07). $71,429

(iv) Step 3 : Corpus required to produce D’s annuity if D had survived C ($10,000/0.07).

$142,857

(v) Step 4 : Present value of C’s interest. $40,000

(vi) Step 5 : The amount determined in Step 3, reduced by the amount determined in Step 4, but not to below the amount determined in Step 2 ($142,857 - $40,000, but not less than $71,429).

(vii) Step 6 : The lesser of the amounts determined in Steps 5 and 1 ($102,857 or $120,000).

$102,857

$102,857.

(3) Effective/applicability dates . - - All but the last two sentences at the end of paragraph (c)(1)(i) of this section are applicable to the estates of decedents dying after August 16, 1954. The first, second, and sixth sentences in paragraph (c)(2)(i) of this section and all but the introductory text, Example 7, and Example 8 of paragraph (c)(2)(iv) of this section are applicable to the estates of decedent’s dying on or after July 14, 2008. Paragraph (b)(1)(ii) of this section, the last two sentences at the end of paragraph (c)(1)(i) of this section, Example 1 of paragraph (c)(1)(ii) of this section, the third, fourth, and fifth sentences in paragraph (c)(2)(i) of this section; paragraph (c)(2)(ii) of this section; paragraph (c)(2)(iii) of this section; and the introductory text, Example 7, and Example 8 of paragraph (c)(2)(iv) of this section are applicable to the estates of decedents dying on or after November 8, 2011.

Steven T. Miller, Deputy Commissioner for Services and Enforcement.

Approved October 27, 2011.

Emily S. McMahon, Acting Assistant Secretary of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on November 7, 2011, 8:45 a.m., and published in the issue of the Federal Register for November 8, 2011, 76 F.R. 69126)

Section 3121.—Definitions

26 CFR 3121(b)(3)–1: Family employment.

T.D. 9554

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 31 and 301

Extending Religious and Family Member FICA and FUTA Exceptions to Disregarded Entities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains final and temporary regulations amending 26 CFR parts 31 and 301. These regulations extend the exceptions from taxes under the Federal Insurance Contributions Act (“FICA”) and the Federal Unemployment Tax Act (“FUTA”) under sections 3121(b)(3) (concerning individuals who work for certain family members), 3127 (concerning members of religious faiths), and 3306(c)(5) (concerning persons employed by children and spouses and children under 21 employed by their parents) of the Internal Revenue Code (“Code”) to entities that are disregarded as separate from their owners for federal tax purposes. The temporary regulations also clarify the existing rule that the owners of disregarded entities, except for qualified subchapter S subsidiaries, are responsible for backup withholding and related information reporting requirements under section 3406. The text of the temporary

regulations also serves as the text of the proposed regulations (REG–136565–09) set forth in the notice of proposed rulemaking on this subject in this issue of the Bulletin .

DATES: Effective Date: These regulations are effective on November 1, 2011.

Applicability Date: For dates of applicability see §§31.3121(b)(3)–1T(e), 31.3127–1T(d), 31.3306(c)(5)–1T(e), 301.7701–2T(e)(5).

FOR FURTHER INFORMATION CONTACT: Joseph Perera (202) 622–6040 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

Background

This document contains final and temporary regulations amending the Employment Tax Regulations (26 CFR part 31) and the Procedure and Administration Regulations (26 CFR part 301) to extend the FICA and FUTA exceptions for family members and religious sect members to certain entities that are disregarded as separate from their owners for federal tax purposes under §301.7701–2(c). Section 301.7701–2(c)(2)(i) provides that generally, except as otherwise provided, a business entity that has a single owner and is not a corporation under §301.7701–2(b) is disregarded as an entity separate from its owner. Prior to 2009, single-member entities disregarded as separate from their owners were generally disregarded for employment taxes and certain other requirements of law arising under subtitle C. An employer is generally defined as the person for whom an individual performs services as an employee. Sections 3401(d), 3121(d), and 3306(a). Prior to 2009, the owner

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ulations in §301.7701–2(c). The inability of these entities to benefit from the exceptions for family employees and members of religious faiths has an adverse impact on small businesses. Accordingly, a change is necessary to correct this problem.

While §301.7701–2(c)(2)(iv) treats an entity that is disregarded as an entity separate from its owner as a corporation for employment tax purposes, such entity remains disregarded for backup withholding and related information reporting purposes. The preamble to Treasury Decision 9356, 2007–2 C.B. 675, which finalized the changes to §301.7701–2(c) indicates that these regulations do not apply to reportable payments under section 3406. Accordingly, the owner of the disregarded entity is responsible for any backup withholding that is required with respect to reportable payments considered made by the owner rather than the disregarded entity, other than a qualified subchapter S subsidiary. However, the final regulations themselves do not explicitly state that such disregarded entities are not responsible for information reporting and backup withholding. This has caused some confusion as to the responsible party for filing information returns for reportable payments and related backup withholding requirements. Therefore, language has been added to these regulations to clarify the existing rules with respect to backup withholding and related information reporting responsibilities.

Explanation of Provisions

The temporary regulations would allow certain disregarded entities under §301.7701–2 to qualify for the FICA and FUTA exceptions of sections 3121(b)(3), 3127 and 3306(c)(5). The disregarded entity will continue to be treated as a corporation for all employment tax purposes, except the entity will be disregarded for the limited purposes of applying the FICA and FUTA exceptions found in sections 3121(b)(3), 3127 and 3306(c)(5). For purposes of applying these exceptions only, the owner of the disregarded entity will be treated as the employer and the employee will be considered to be an employee of the owner. Additionally, the regulations clarify the existing rule that disregarded entities under §301.7701–2 are not responsible for backup withholding

of the disregarded entity was treated as the employer for purposes of employment tax liabilities and all other employment tax obligations related to wages paid to employees performing services for the disregarded entity.

Recent changes to §301.7701–2(c)(2)(iv) provide that, with respect to wages paid after December 31, 2008, a disregarded entity is treated as a separate entity for purposes of employment taxes imposed under Subtitle C and related reporting requirements. In addition, the separate entity is treated as a corporation for purposes of employment taxes imposed under Subtitle C and related reporting requirements. Therefore, the entity, rather than the owner, is considered to be the employer of any individual performing services for the entity.

Sections 3111 and 3301 of the Code impose FICA and FUTA taxes, respectively, on the employer in an amount equal to a percentage of the wages paid by that employer with respect to employment. Under section 3101, FICA tax is also imposed on the employee. Sections 3121(b) and 3306(c) define employment for FICA and FUTA purposes as any service, of whatever nature, performed by an employee for the person employing him. However, there are some services which are explicitly excepted from the definition of employment. For example, section 3121(b)(3)(A) provides that service performed by a child under the age of 18 in the employ of his father or mother is not considered employment for FICA purposes. Section 3121(b)(3)(B) provides that service performed by an individual under the age of 21 employed by his father or mother, or performed by an individual employed by his spouse or son or daughter (subject to certain conditions) for domestic service in a private home of the employer is not considered employment for FICA purposes. Section 3306(c)(5) provides that service performed by an individual in the employ of his son, daughter, or spouse, and service performed by a child under the age of 21 in the employ of his father or mother are not considered employment for FUTA purposes.

Prior to the recent changes to §301.7701–2(c), the services a family member performed for a disregarded entity wholly owned by another family member could qualify for the exceptions under sections 3121(b)(3) and 3306(c)(5)

if all the requirements were satisfied, as the individual family member owner was treated as the employer. However, due to the recent changes to the regulations, family members can no longer qualify for the FICA and FUTA exceptions that apply to family employment because §301.7701–2(c)(2)(iv) regards the disregarded entity as a separate entity and treats the separate entity as a corporation for employment tax purposes. Sections 31.3121(b)(3)–1(c) and 31.3306(c)(5)–1(c) explicitly state that services performed in the employ of a corporation are not within the exceptions from employment that apply because of the existence of a family relationship between the employee and the individual employing him.

Section 3127 provides an exception from FICA taxes where both the employer and the employee are members of a religious faith opposed to participation in the Social Security Act. Both the employer and the employee must be members of a recognized religious sect and both must have filed and had approved an application certifying that they are members of a qualifying religious faith. Prior to the recent changes made to §301.7701–2(c), service performed by a member of a qualifying religious sect for a disregarded entity wholly owned by another member of a qualifying religious sect could qualify for this exception as the individual sect member was considered to be the employer. However, as a result of the recent changes to §301.7701–2(c)(2)(iv), the disregarded entity is regarded as a separate entity for employment tax purposes and the separate entity is treated as a corporation. As a corporation, the entity cannot be considered a member of a qualifying religious sect. Therefore, the exception cannot apply, as the employer would not be a member of a qualifying religious sect.

Section 301.7701–2(c)(2)(iv) treats disregarded entities as corporations for employment tax purposes. Such entities cannot qualify for the FICA and FUTA exceptions contained in sections 3121(b)(3), 3127, and 3306(c)(5) because the individual owner is no longer considered the employer. The IRS and the Treasury Department did not intend to render these exceptions inapplicable to disregarded entities that were eligible for the exceptions prior to the effective date of the new reg

2011–50 I.R.B. 844 December 12, 2011

had approved applications under section 3127(b) for exemption from the taxes imposed by sections 3111 and 3101 then the employer is exempt from taxes imposed by section 3111 with respect to the wages paid to the eligible employee, and the employee is exempt from the taxes imposed by section 3101 with respect to the wages paid by that employer.

(b) Services performed in the employ of a corporation are not within the exception, except as provided in paragraph (c) of this section.

(c) A disregarded entity that is treated as a corporation under §301.7701–2(c)(2)(iv)(B) of this chapter (Procedure and Administration Regulations) shall not be treated as a corporation for purposes of applying section 3127. For purposes of section 3127, the owner of the disregarded entity will be treated as the employer and the payor of the employee’s wages.

(d) This section applies with respect to wages paid on or after November 1, 2011. However, taxpayers may apply this section to wages paid on or after January 1, 2009.

(e) Expiration date . The applicability of this section expires on or before October 31, 2014.

Par. 5. Section 31.3306(c)(5)–1 is amended by revising paragraph (c) and adding paragraphs (d) and (e) to read as follows:

§31.3306(c)(5)–1 Family Employment.

- - - (c) [Reserved]. For further guidance, see §31.3306(c)(5)–1T(c).

(d) [Reserved]. For further guidance, see §31.3306(c)(5)–1T(d).

(e) [Reserved]. For further guidance, see §31.3306(c)(5)–1T(e).

Par. 6. Section 31.3306(c)(5)–1T is added to read as follows:

§31.3306(c)(5)–1T Family employment (temporary).

(a) [Reserved]. For further guidance, see §31.3306(c)(5)–1(a).

(b) [Reserved]. For further guidance, see §31.3306(c)(5)–1(b).

(c) Services performed in the employ of a corporation are not within the exception, except as provided in paragraph (d) of this section. Services performed in the

and information reporting of reportable payments under section 3406. Rather, the owner of a disregarded entity under §301.7701–2 is responsible for backup withholding and information reporting of reportable payments under section 3406. This does not change the existing rule.

Special Analyses

It has been determined that this Treasury Decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, this regulation will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Joseph Perera, Office of Associate Chief Counsel (Tax Exempt & Government Entities). However, other personnel from the IRS and Treasury Department participated in their development.

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Amendments to the Regulations

Accordingly, 26 CFR parts 31 and 301 are amended as follows:

PART 31—EMPLOYMENT TAXES AND COLLECTION OF INCOME TAX AT SOURCE

Paragraph 1. The authority citation for part 31 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 31.3121(b)(3)–1 is amended by revising paragraph (c) and adding paragraphs (d) and (e) to read as follows:

§31.3121(b)(3)–1 Family employment.

- - - (c) [Reserved]. For further guidance, see §31.3121(b)(3)–1T(c).

(d) [Reserved]. For further guidance, see §31.3121(b)(3)–1T(d).

(e) [Reserved]. For further guidance, see §31.3121(b)(3)–1T(e).

Par. 3. Section 31.3121(b)(3)–1T is added to read as follows:

§31.3121(b)(3)–1T Family employment (temporary).

(a) [Reserved]. For further guidance, see §31.3121(b)(3)–1(a).

(b) [Reserved]. For further guidance, see §31.3121(b)(3)–1(b).

(c) Services performed in the employ of a corporation are not within the exceptions, except as provided in paragraph (d). Services performed in the employ of a partnership are not within the exception unless the requisite family relationship exists between the employee and each of the partners comprising the partnership.

(d) A disregarded entity that is treated as a corporation under §301.7701–2(c)(2)(iv)(B) of this chapter (Procedure and Administration Regulations) shall not be treated as a corporation for purposes of applying section 3121(b)(3). For purposes of applying section 3121(b)(3), the owner of the disregarded entity will be treated as the employer.

(e) Paragraphs (c) and (d) of this section apply with respect to wages paid on or after November 1, 2011. However, taxpayers may apply paragraphs (c) and (d) of this section to wages paid on or after January 1, 2009. (f) Expiration date . The applicability of paragraphs (c) and (d) of this section expires on or before October 31, 2014.

Par. 4. Section 31.3127–1T is added to subpart B to read as follows:

§31.3127–1T Exemption for employers and their employees where both are members of religious faiths opposed to participation in Social Security Act programs (temporary).

(a) If an employer (or if the employer is a partnership, each partner therein) and their employee are members of a recognized religious sect or division described in section 1402(g)(1) of the Code, both the employer and employee adhere to the tenets and teachings of that sect, and both the employer and employee have filed and

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(B) [Reserved]. For further guidance, see §301.7701–2(c)(2)(iv)(B).

(C) Exceptions . For exceptions to the rule in §301.7701–2(c)(2)(iv)(B), see sections 31.3121(b)(3)–1(d), 31.3127–1(c), and 31.3306(c)(5)–1(d).

(D) through (e)(4) [Reserved]. For further guidance, see §301.7701–2(c)(2)(iv)(D) through (e)(4).

(5) Paragraphs (c)(2)(iv)(A) and (c)(2)(iv)(C) of this section apply to wages paid on or after November 17, 2011. For rules that apply to paragraph (c)(2)(iv)(A) of this section before November 17, 2011, see 26 CFR part 301 revised as of April 1, 2009. However, taxpayers may apply paragraphs (c)(2)(iv)(A) and (c)(2)(iv)(C) of this section to wages paid on or after January 1, 2009.

(e)(6) through (e)(7) [Reserved]. For further guidance, see §301.7701–2(e)(6) through (e)(7).

(8) Expiration Date . The applicability of paragraphs (c)(2)(iv)(A) and (c)(2)(iv)(C) of this section expires on or before November 14, 2014.

Steven T. Miller, Deputy Commissioner for Services and Enforcement.

Approved November 19, 2011.

Michael Mundaca, Assistant Secretary of the

Treasury (Tax Policy).

(Filed by the Office of the Federal Register on November 9, 2011, 8:45 a.m., and published in the issue of the Federal Register for November 10, 2011, 76 F.R. 70057)

employ of a partnership are not within the exception unless the requisite family relationship exists between the employee and each of the partners comprising the partnership.

(d) A disregarded entity that is treated as a corporation under §301.7701–2(c)(2)(iv)(B) of this chapter (Procedure and Administration Regulations) shall not be treated as a corporation for purposes of applying section 3306(c)(5). For purposes of applying section 3306(c)(5), the owner of the disregarded entity will be treated as the employer.

PART 301—PROCEDURE AND ADMINISTRATION.

Par. 7. The authority citation for part 301 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 8. Section 301.7701–2 is amended by:

Revising paragraph (c)(2)(iv)(A).
Redesignating paragraph (c)(2)(iv)(C) as paragraph (c)(2)(iv)(D) and adding new paragraph (c)(2)(iv)(C).

§301.7701–2 Business entities; definitions.

- - - (C) [Reserved]. For further guidance, see §301.7701–2T(c)(2)(iv)(C).
- - - Par. 9. Section 301.7701–2T is added to read as follows:

§301.7701–2T Business entities; definitions (temporary).

(a) through (c)(2)(iv) [Reserved]. For further guidance, see §301.7701–2(a) through (c)(2)(iv).

(A) In general . Section §301.7701–2(c)(2)(i) (relating to certain wholly owned entities) does not apply to taxes imposed under Subtitle C—Employment Taxes and Collection of Income Tax (Chapters 21, 22, 23, 23A, 24 and 25 of the Internal Revenue Code). However, §301.7701–2(c)(2)(i) does apply to withholding requirements imposed under section 3406 (backup withholding). The owner of a business entity that is disregarded under §301.7701–2 is subject to the withholding requirements imposed under section 3406 (backup withholding). Section 301.7701–2(c)(2)(i) also applies to taxes imposed under Subtitle A, including Chapter 2—Tax on Self Employment Income. The owner of an entity that is treated in the same manner as a sole proprietorship under §301.7701–2(a) will be subject to tax on self-employment income.

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